Proposed Legislation to Change Estate and Gift Tax Planning

Real Estate Investing can be one of the greatest sources to build wealth. Timing and knowledge are the keys to successful investing. Whether you are just starting out or have a multitude of investments, it is important to protect your assets and stay on top of proposed tax changes. It is critical to build a solid “team” around you of key relationships including financial/wealth advisors, accountants and real estate experts in the area of which you are looking. Below is a good read from the estate planning team at Stoel-Rives LLP. For more information on real estate opportunities in Tamarack Resort, McCall and Donnelly, contact Trish Sears at 208-573-1489 or trisha@trishasears.com.

September 22, 2021

Proposed Changes to Estate, Gift, and GST Taxes Author – Stoel Rives LLP

Democrats recently unveiled the Build Back Better Act, which, if passed, would bring significant changes to the Tax Code and would have a drastic impact on common estate planning techniques, including gifts to trusts. The House Ways and Means Committee approved the plan on September 15, 2021, and now the legislation must work its way through the House Rules Committee and the House at large before going to the Senate.

The focus of this alert is on estate planning changes, which include lowering of the estate, gift, and generation-skipping transfer (also known as “transfer tax”) exemptions. The estate planning aspects will be covered in a future alert about the proposed changes subjecting certain irrevocable grantor trusts to the estate tax, and attempting to overhaul the “grantor trust” income tax rules. We will cover the proposals to increase ordinary income and capital gains tax rates for high-income earners in a future alert as well. Please note this is only proposed legislation and will almost certainly change before it is enacted.

Lower Gift and Estate Exemptions

The proposals reduce the federal estate and gift tax exemption from the current $11.7 million (inflation-adjusted for 2021) to $5 million (inflation-adjusted) effective January 1, 2022, instead of January 1, 2026. The inflation-adjusted exemption is anticipated to be about $6 million.

Some potential changes that had been previously discussed did not appear in this proposal. The 40% estate and gift tax rate did not change. The estate and gift tax changes are not retroactive. There is no limit on the number of annual exclusion gifts, and generation-skipping or dynasty trusts are not limited to 90 years if governed by state law that permits a longer duration.

Because the reduced exemption is not effective until January 1, 2022, there is a period for possible tax planning in advance of the impending changes. We recommend considering using the 2021 exemption to move assets out of your estate by December 31, 2021 (or prior to enactment, if grantor trusts are used). For example, if you have been considering making gifts using your remaining gift tax exclusion and/or GST exemption amounts but have been worried about the potential for retroactivity, the proposed changes may provide you with sufficient comfort to proceed with the gifts before the end of 2021. If you are considering a complex strategy, such as a sale or gift to a grantor trust or the gifting of discounted assets, the trust must be created sooner rather than later because the changes to grantor trusts would become effective upon the enactment of the legislation, as we will discuss more in our next alert. All of the other factors that must be considered when gifting are still factors, such as the income tax implications of the loss of the step-up in basis and the loss of control and use of the asset. These factors were discussed in prior alerts (see Post-Inauguration Estate Planning: Should Large Gifts Be Made Now? and Gift-Giving and Other Planning Under the New Political Landscape).

Valuation Discounts

Valuation discounts have been challenged by the IRS for many years. If an individual owns a closely held business interest that is not publicly traded and does not have voting control, it is unlikely that a third-party purchaser would purchase the interest for its liquidation value (i.e., the partnership interest’s pro-rata value of the underlying assets in the partnership). Rather, a third-party purchaser would want a discount from the liquidation value. For transfers of interests in a closely held entity, the proposals eliminate valuation discounts for lack of control or lack of marketability that are attributable to the nonbusiness assets held by the entity. Nonbusiness assets are passive assets that are held for the production of income and not used in the active conduct of a trade or business. Exceptions are provided for assets used as working capital of a business.

This provision is designed to eliminate the strategy of creating family LLCs or limited partnerships to hold passive assets (i.e., a portfolio of stocks, bonds, or mutual funds), and have the LLC or partnership valued for gift and estate tax purposes at a lesser value due to discounts for lack of marketability and minority interests. This change would be effective for transfers made after the effective date of the legislation, so it would be important to make discounted gifts of entities holding passive assets in the very near future. Discounts will likely not be available for year-end gifts of entities holding passive assets.

Below covers the proposed changes to certain irrevocable trusts, called grantor trusts, and the changes would be effective upon the date of enactment. As we mentioned before, this is only proposed legislation and will almost certainly change before it is enacted.

Currently, individuals are able to retain certain interests in trusts that cause the grantor to be the owner of the trust for income tax purposes but without resulting in inclusion of the trust assets in the grantor’s taxable estate at death. We refer to these trusts as “grantor trusts.” The proposed legislation would cause the assets of grantor trusts to be brought back into the grantor’s taxable estate at death. In addition, any distribution from a grantor trust to anyone other than the grantor or the grantor’s spouse would be considered a taxable gift by the grantor to that person, and the grantor would be treated as making a gift of all the trust’s assets if the trust ceased to be a grantor trust during the grantor’s lifetime.

Grantor trusts have also had income tax benefits. Individuals who are considered owners of grantor trusts have had the ability to sell assets to the trust and often have retained the power to exchange their own assets with assets of the trust, both with no income tax cost. The new law would trigger gain recognition upon sales and exchanges between the trust and the grantor. These changes, if passed, would be effective upon enactment of the new legislation. While the assets of existing grantor trusts and grantor trusts signed and funded before the effective date would not be brought back into the grantor’s taxable estate, sales to existing grantor trusts would result in gain recognition, and future contributions to existing grantor trusts would cause a portion of the trust’s assets to be taxable at death. We also expect that exchanges of assets between the grantor and the trust would trigger gain recognition. The use of irrevocable grantor trusts would no longer be beneficial, as highlighted below.

Irrevocable Life Insurance Trusts – Individuals create irrevocable life insurance trusts (“ILITs”) to remove their life insurance policies and the proceeds thereof from their gross estates. However, contributions of cash to an ILIT after the effective date would cause inclusion of a portion of the insurance proceeds in the grantor’s taxable estate. Depending on the facts and circumstances of your particular situation, you may consider pre-funding premium payments this year to avoid making contributions in future years.

Grantor Retained Annuity Trusts – A grantor retained annuity trust (“GRAT”) is an irrevocable trust to which an individual contributes appreciating assets with very low gift tax and retains the right to a specified annuity payment for a fixed term of years. At the end of the term, the annuity payments end and the trust beneficiaries receive the remaining trust assets – with no additional transfer tax, the idea being that the assets will appreciate at a rate higher than the annuity. Under the proposed legislation, at the end of the GRAT, the distribution of the remaining trust assets would be considered a gift that is equal to the value of the transferred property. Further, appreciated assets that are used to make an annuity payment to the grantor would be considered a deemed sale and trigger capital gain.

Spousal Lifetime Access Trust – We discussed spousal lifetime access trusts (“SLATs”) in a prior alert (Using Spousal Lifetime Access Trusts to Lock in High Estate Tax Exemption Amounts). SLATs are grantor trusts by virtue of the fact that the grantor is creating a trust for the benefit of the grantor’s spouse. Under the new legislation, a SLAT would no longer be a viable estate planning tool as the assets would be included in the grantor’s taxable estate.

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